Is the Fed Backing Itself Into a Corner?

By now, everyone knows that the Fed cut the federal funds rate, by 75 basis points Tuesday, to 2.25%. But was this the right strategy? Really, the Fed had to do it, given the recent "difficulties" at Bear Stearns (BSC) and other financial institutions. It seems like I said that a few months ago when Countrywide (CFC), American Home and Northern Rock had difficulties. Back then, mortgage backed securities became tough, if not impossible, to sell, and this created a crisis of confidence and liquidity that threatened better capitalized companies. And as that crisis has continued to the present time, the consequences of not cutting the rate would have been grim. Or would they?

If another rate cut was the right short-term strategy, I believe the hand of the current Fed was forced by Greenspan, who left rates too low for too long, a lax policy that created many of the current problems. The federal funds rate was below 2.0% for most of 2002 to 2004. And from June 2003 to June 2004 the rate was 1.0%. This created negative "real" interest rates for much of this time period. The last time the federal funds rate was so low was the late 1950's, another period of recession (see the chart below).

So why does it matter if real interest rates are negative?

Consider the following formula: Nominal Interest Rate = Real Interest Rate + Inflation.

Therefore, the Real Interest Rate = the Nominal Interest Rate - Inflation.

If inflation is higher than the nominal interest rate, clearly the real interest rate is negative. Recently the rate of inflation exceeded 4.0%. This rate can be calculated using the Consumer Price Index which is published monthly by the Bureau of Labor Statistics. Core inflation, which excludes food and energy was lower at 2.4% over the past 12 months. If the nominal federal funds rate is 2.25%, subtracting 4.0% inflation gives a real rate of -1.75%. The discount rate, the rate at which member banks can borrow short term funds directly from the Fed, was lowered as well to 2.5%. Its corresponding real rate would be -1.5%.

So what does all this mean?

Negative real rates are unsustainable for any extended period. They are a subsidy; i.e., they are below what a "real" market rate would be. Where does the money for the subsidy come from? It comes from the taxpayers, collectively. What if the taxpayers don't have the funds? I guess the government has to borrow against future earnings, increasing debt levels.

What's the logic? An AP story Tuesday said "The Fed action was designed to lower borrowing costs and boost spending by consumers and businesses and thus increase economic activity." No doubt, it was also designed to ease margins for financial institutions. But if you really believe in Capitalism, shouldn't companies that are unprofitable, even major ones, go out of business, rather than be propped up through subsidized interest rates? Should we see that as a form of economic socialism?

It certainly raises questions. And while the intent may be to encourage more consumption, the personal savings rate in America is less than 1% of disposable income. Nominal interest rates below inflation (negative real rates) are a disincentive to saving. I found one money market at a major bank offering 1.34% and that's if your balance is over $100,000! Would you put your money there? Another problem with negative real rates is that money will move out of markets where rates are negative, as investors will lose purchasing power. It will move to markets which offer higher real rates; in other words, capital flight. Those markets could include the EU, where the ECB's key rate is 4.0%, or Australia where the central bank recently increased its key rate to 7.25%.

I think the better strategy for the government would have been to allow the recession of the early 2000's to run its course, not to inflate our way out of it. But that is a done deal. And it seems the strategy is in vogue again. But at some point, it is better to deal with things head on. And with the federal funds rate at 2.25%, the Fed doesn't have a lot of room left to cut if more problems arise.